Key Takeaways:

  • The rapid rise of interest in leveraging Bitcoin for more than just transfers has many investors looking at Bitcoin-centric scaling solutions. Stacks could be a prime beneficiary of this trend with many exciting developments on the near horizon.
  • The STX token offers passive BTC yield for stackers that help operate the network, whereby increased usage of Stacks results in higher STX yields.
  • Stacks experienced a critical bug on April 19, 2023 that enabled an individual address to falsify their STX stack balance, which resulted in a $425k profit. This bug would have been detrimental to the safety of sBTC.
  • The Proof-of-Transfer (PoX) consensus mechanism is actively being abused by an entity censoring its competition and taking more STX rewards than it is entitled to.
  • Stacks uses economic disincentives instead of economic penalties to align ecosystem participants, but it remains to be seen if that will be enough to create a secure BTC bridge and a reliable native price oracle.

The rise of inscriptions and the Ordinal Theory, which gives users the ability to inscribe individual Satoshis with arbitrary data, has sparked a renewed interest in innovations leveraging Bitcoin. With the next Bitcoin halving less than a year away, many investors are looking for the best way to gain high beta exposure to BTC amidst the growing narrative. STX, the native token of the Bitcoin L2 called Stacks, has seen an increasing amount of investor interest and has the potential to be one of the primary beneficiaries of this trend with its Nakamoto upgrade slated for the back half of 2023. However, the recent woes experienced on the network as well as the nascency of Bitcoin scaling solutions are enough to warrant investor caution.

Bitcoin Scaling Overview

Stacks is a smart contract platform that inherits certain security properties from Bitcoin while providing Bitcoin-centric users an environment to interact with DeFi applications, NFTs, and more. The project launched in 2021 and supports a programming language called Clarity, Bitcoin-settled transactions, and atomic swaps between BTC and other digital assets on the Stacks chain. Stacks now secures over $35M of TVL, but ~95% of the capital is on a single DEX called ALEX. It will be important for Stacks to attract a large ecosystem of developers to build out a rich set of dapps in order to attract users.

In Stacks’ defense, Bitcoin is not able to support traditional L2 architectures without underlying changes being made to Bitcoin at the opcode level, which has proven to be a slow and highly debated process throughout history. Additionally, bootstrapping a chain with a new programming language takes years of iteration to build out developer tooling, block explorers, a robust validator set, etc. Stacks differentiates itself from other Bitcoin scaling solutions with its novel consensus mechanism, ambitious plans for subnets, and a unique BTC bridge. RSK is the main competitor attempting to bring smart contract development to Bitcoin, but the bridge relies on a trusted set of signers through what is called a ‘Federated Multisig’ approach.

The Lightning Network is arguably the most widely adopted Bitcoin scaling solution given its integration with projects like Strike, Nostr, and others, but it focuses solely on cheaper payments using BTC. Liquid secures a notable amount of capital, but chose to focus on financial infrastructure with trust assumptions over the permissionless deployment of smart contracts that inherit some of Bitcoin’s security properties. That leaves us with RSK and Stacks as the leading projects tackling smart contracts on Bitcoin. However, RSK also relies on a trusted set of signers (Federated Multisig) for BTC peg-ins/outs e.g. mints and burns of sBTC when traveling between Bitcoin and Stacks.

It is worth noting that the above table focused solely on BTC TVL at the L2 level. In our view, this is the most important metric to track because the main reason to build a Bitcoin-centric L2 is two-fold; create more utility for otherwise idle BTC and stronger security guarantees for a smart contract layer to prevent chain re-orgs or double-spend attempts. To the former point, the demand to use BTC as collateral in Ethereum DeFi via wBTC has been in a downtrend since the CeFi implosions experienced in 2022. While the declining supply may be a direct result of the bankruptcy liquidation proceedings, it is worth tracking onchain users' demand to use BTC in a smart contract-enabled environment.

In regards to the latter point, the demand for Bitcoin’s underlying security properties has been exemplified through the rise of Ordinals and various attempts at creating token standards directly on Bitcoin. However, the activity around these use cases has looked more speculative in nature than a genuine use case thus far. This makes sense considering the lack of utility for JPEGs and tokens at the Bitcoin base layer, but it is possible for a chain like Stacks to provide the infrastructure that enables programmability for arbitrary data that inherits Bitcoin-grade immutability.

Proof of Transfer (PoX)

PoX is Stacks’ novel consensus mechanism that attempts to recycle the energy expended under Bitcoin’s PoW consensus by probabilistically awarding a Stacks miner that sends BTC to two separate STX stacker addresses with the right to add the next block to the chain. The more BTC that is transferred by a miner in proportion to other miners, the higher the chance that miner wins the right to append the next block to earn STX transaction fees and block rewards. In other words, Stacks miners spend BTC, in the same way BTC miners expend electricity, in order to mint new STX tokens. Anyone with a node and wallet on the Stacks and Bitcoin chains (assuming there is a BTC balance willing to be spent) can participate in mining.

STX holders can stake, or ‘stack’, their tokens in exchange for the BTC spent by competing Stacks miners. Stackers are also tasked with signaling their support for the longest chain in the case of a fork choice. The amount of STX that must be stacked in order to earn rewards is dependent upon the total amount of the liquid supply that is stacked. On April 19, 2023, Stacks experienced a critical bug that miscalculated how much STX was stacked by a single address. It has not been confirmed whether or not this was a deliberate attack, but the wallet accrued over 15 BTC of miner expenditures from April 10 to April 30 before the Stacks core team decided to resort to burning miner payouts and unlocking all of the stacked STX. Nodes would have entered into an irrecoverable state had the amount of stacked STX surpassed the liquid supply total. A notable takeaway is that unlike in PoS networks, stackers cannot be slashed, so the disincentive to misbehave is simply the forgoing of BTC rewards. An update is slated for May 26, 2023 that will return the network back to its PoX consensus model. Also, the bug stemmed from code written in Clarity, which exemplifies the struggles that come alongside bootstrapping a new programming language.

sBTC

In contrast to solutions such as RSK and Liquid, Stacks does not yet have a native method for minting synthetic BTC (bridging). Instead, the BTC derivative used on Stacks is xBTC: A BTC derivative token with Anchorage acting as the default custodian for the underlying backing. This has proven to be a problem for Stacks because many BTC holders do not feel comfortable using a trusted 3rd party bridging solution, which is counterproductive to the Stacks core team’s goal of onboarding the $500B of idle BTC capital into DeFi. This could also be a large reason why many Bitcoin L2s have failed to gain significant traction.

In the back half of 2023, Stacks will introduce sBTC: a synthetic BTC asset with a peg maintained 1:1 with BTC through economic incentives involving the STX token. STX stackers are charged with signing peg-out transactions and maintaining the BTC:sBTC peg in exchange for the BTC yield they receive from Stacks miners. Miners are incentivized to follow the canonical Stacks chain in exchange for STX block rewards and transaction fees. The supply cap on sBTC is set to 60% of the total value of all STX stacked in an attempt to ensure an attacker would stand to lose more by signing invalid peg-out transactions.

The supply cap is determined via the consensus protocol mechanism that prices the BTC/STX exchange rate using the 90 day moving average. If the value of sBTC ever surpassed 60% of the stacked STX value, minting would be disabled until further withdrawal requests were processed. This is a great method for removing the reliance on centralized oracle providers and improving decentralization, but it comes with tradeoffs. A stacker with 70% of the total value stacked is able to single-handedly sign BTC peg-outs, manipulate the BTC/STX exchange rate, or choose a malicious fork choice on the Stacks chain. If sBTC had been live during the bug experienced in April, the damage could have been much worse.

Nakamoto Upgrade

Stacks has been plagued by Bitcoin’s ~10 minute block times but will introduce a performance improvement via the Nakamoto upgrade. ‘Fast Blocks’ will be processed every 5 seconds using BFT-style quorum signing in between ‘Settlement blocks,’ or blocks that settle down to Bitcoin in order to reduce latency, increase throughput, and improve network predictability. A group of Stacks miners are elected every Settlement block to mine Fast blocks for the following ~10 minutes before the next Settlement block is appended at the base layer. Therefore, there are roughly 120 Fast blocks for every Settlement block hash that’s posted to Bitcoin. Fast blocks will never fork given their BFT nature, but Settlement blocks are subject to reorgs.

The Stacks chain is considered as final and immutable as the Bitcoin chain itself after 150 Settlement blocks (~1 day) have been confirmed at the base layer. The only transactions that are maintained by the security budget of Stacks (BTC miner payments, STX block subsidies, and transaction fees) equate to about a day’s worth of the chain’s history. However, 18,000 blocks is a substantial amount of time to rely on a security budget that equates to just 150k STX and ~3.81 BTC (~$200k) per day. While it is true that an increasing amount of activity will result in more STX fees and higher STX miner bribes accruing to Stackers, a significant growth in activity on Stacks will only increase the incentive for node operators to act maliciously. PoX underpins the security of the entire system, and as a novel consensus mechanism, it is critical to be cognizant of the risks.

Due to the potential for a reorg on the Bitcoin layer, Stacks miners are able to fork the chain up to a depth of 6 settlement blocks. Once the settlement block reaches a depth of 7, the only way to initiate a fork is with a +70% vote from STX Stackers and would only be used under extreme circumstances. It is worth noting that reorgs are relatively uncommon on Bitcoin and typically don’t exceed 1 block when they do occur, so this failsafe is likely in place in case the Stacks execution environment comes under attack.

Another update to look forward to is the introduction of subnets. For those familiar with Avalanche and Polygon, this will sound quite familiar. Subnets are essentially alternate execution environments tailored for a specific use case that can settle transactions to the Stacks layer and ultimately finalize on the Bitcoin network. Smart contracts deployed on Stacks subnets can support the STX and sBTC tokens and trigger writes on the Bitcoin main chain through the Stacks layer. While the idea of an EVM-compatible Stacks subnet is exciting, it is unclear how cross-subnet communication will work and how limited the EVM (or other VM) implementation would be given the constraints of Bitcoin’s time to finality.

For nearly half a year, the Stacks mining landscape has been faced with a massive problem related to centralization/censorship that has largely gone unnoticed outside of the Stacks community. If you recall, the right to append the next Stacks block is probabilistically determined based upon the amount of Sats sent by the miner. However, not many people have considered what would happen if a Bitcoin miner was also an STX miner. F2Pool, one of the largest BTC mining pool operators with a ~16% market share, happens to be both a BTC and an STX miner. It has been abusing its position of power by censoring transactions in Bitcoin blocks coming from competing Stacks miners to guarantee it wins the STX block reward regardless of the amount of Sats that are sent to STX stackers.

Typically, Stacks miners must participate in the mining process for numerous blocks before having a realistic chance to win in order to ensure consistent participation in the network’s consensus. Otherwise, a miner would only participate in consensus if it saw minimal competition in the next block. Even though the miner’s chance of winning the next Stacks block is negligible upon immediately joining the network, if they are the only transaction included within a Bitcoin block, they will still win given they are the only one competing. F2Pool is simply removing the lowest value transactions from the block it constructs on Bitcoin, ignoring any other competing Stacks miners’ transactions, and then including its own block-commit to guarantee it wins the STX fees and block rewards regardless of the number of Sats it sent. Historically F2Pool has been able to pay a few hundred Sats, plus transaction fees, for 1k STX tokens. In other words, F2Pool is making ~$640 for just a few bucks every time it mines a Stacks block.

This not only puts downward pressure on STX's BTC staking yield, but it also creates a centralizing force in Stack’s PoX consensus, and serves as a live example of outright censorship. It will also be critical to have a competitive block building marketplace once sBTC goes live since the BTC yield is the primary factor incentivizing STX stackers to only sign honest peg-out requests given the absence of slashing. It does not appear that the miner is directly censoring individual Stacks users’ transactions, but it certainly has the power to do so. From September 2022 to March 2023, F2Pool controlled anywhere from 70-100% of the Stacks mining power. Even if an external miner manages to win a Stacks block, F2Pool can create a sibling Bitcoin block to render the initial Stacks block invalid and strip the original miner of their STX rewards by creating a new canonical Stacks fork.

There is a proposal live on the Stacks governance forum to implement a minimum amount of Sats that need to be sent to Stackers in order to win a Stacks block. This wouldn’t guarantee that F2Pool would give up its monopoly if the operation is still profitable, but it would at least fix the downward pressure on STX stacking yields. Recently, the Stacks Foundation outsourced tokenomic design work around mitigating Bitcoin-derived MEV opportunities as it relates to Stacks. As a silver lining, Stacks has risen in popularity to the point where MEV opportunities are actually profitable and worth paying attention to.

Lastly, multi-block reorgs have become a bigger problem on Stacks in recent months. The problem remains unsolved, but the team issued a statement claiming that the activity did not appear malicious. Although they do believe the issue is stemming from a few large mining groups that could potentially have suboptimal node configurations, connectivity issues between various locations, etc. Reorgs can cause miners to accidentally be dropped from the chain or reduce network throughput. There is no economic incentive for this behavior because neither miner of orphaned blocks receive any compensation.

Final Thoughts

Stacks is undoubtedly one the leaders in the BTC L2 landscape with some exciting changes on the near horizon. A reliable, trustless BTC bridge, the introduction of Fast blocks, subnets, and stronger Bitcoin immutability inheritance could be the missing pieces to Stacks adoption. Its PoX consensus model and unique token design centered around real BTC yield paired with the backdrop of rising interest in leveraging Bitcoin for more than just transfers feels like an easy narrative to get behind.

However, the Stacks team is attempting to solve multiple hard problems all at once. The PoX consensus mechanism is operating as designed, but the rules are actively being abused by Bitcoin/Stacks miners to censor other would-be competition, taking more than their fair share of STX rewards while diluting other stackers in the process. The reorg issue doesn’t look to have a solution in sight and will only become a bigger problem with more Stacks usage. The critical bug that enabled an address to spoof the amount of STX they had staked is a harsh reminder that new programming languages are hard to build out. It’s also unclear if the native BTC/STX price oracle, as well as the sBTC:BTC peg, will actually work in a mainnet environment or if further economic penalties such as slashing are warranted. STX feels like a risky play given all the unknowns around not just the future design of the protocol, but the current implementation as well.